Wall Street's 'Fear Gauge' Spike Indicates a Possible Tipping Point for the Stock Market Rally

After a prolonged period of tranquility, the stock market's remarkable upward trajectory encountered an interruption last week as the "fear gauge" of Wall Street experienced a significant spike, prompting concerns among some analysts that this could herald the onset of a more substantial downturn.

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The Cboe Volatility Index (VIX), also known as the Vix, has sparked worries that stocks might be on the verge of a correction—defined as a decline of 10% or more from recent highs—following a 23% surge in the fear gauge last week, marking its most substantial weekly increase since September. FactSet data indicates that the index closed above 16 for the first time since November 1.

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This sudden spike follows a prolonged period of subdued Vix readings, attributed by experts to various factors including the rise in popularity of "zero-day to expiry" contracts and exchange-traded funds focused on derivative income, which sell option contracts as part of their strategy. Concerns have been raised that an escalation in volatility could become self-sustaining as traders unwind derivative bets predicated on market stability.

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The Vix gauges implied volatility, reflecting traders' expectations regarding stock movements over the coming month based on options market activity. Volatility tends to escalate more rapidly during stock market declines.

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Tyler Richey, co-editor of Sevens Report Research, shared a report with MarketWatch on Monday suggesting that a rising Vix accompanied by increased demand for bearish put options could indicate that the market has reached a critical juncture, potentially leading to further softening in the weeks ahead. Richey opined that a repeat of the selloff experienced by the S&P 500 between late July and late October of the previous year appears to be the most probable scenario for the markets.

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The surge in demand for bearish put options last week drove the 10-day rolling average of the Cboe equity put-call ratio to its highest level since January 26, according to Dow Jones Market Data. This ratio assesses the demand for options tied to individual stocks. Additionally, increased demand for risky out-of-the-money puts drew attention from Charlie McElligott, a derivatives strategist at Nomura, who noted that this caused a rise in a gauge measuring investors' preference for out-of-the-money puts compared to calls.

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McElligott highlighted the sharp increase in this gauge from historically low levels observed in March, indicating a trend that has often coincided with periods of notably weak excess returns for stocks. Excess returns gauge stocks' performance relative to their historical averages during specific periods of the year.

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Collectively, these indicators suggest that markets could be bracing for further short-term turbulence, particularly as investors await the release of the March consumer-price index and contend with a series of Treasury auctions that could impact bond yields. However, other potential catalysts, including a strengthening economy, rising real yields, corporate buyback blackout periods during earnings seasons, and U.S. investors' tax payments, could also contribute to a shift in market dynamics from calm to turbulent, according to McElligott.

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While some analysts caution against overinterpreting last week's volatility spike, they acknowledge that the market rally appears increasingly precarious. Matt and Mike Thompson, co-portfolio managers at Little Harbor Advisors, noted in an interview with MarketWatch that despite the relatively minor crack observed, it is a notable deviation from the prolonged period of market ascent since November.

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In the stock market on Monday, the S&P 500 closed down marginally, the Dow was also slightly lower, and the Nasdaq Composite saw a modest increase. Market activity was notably subdued, possibly influenced by the distraction of a total solar eclipse visible from North America.

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The Vix finished the day lower, marking a 5.1% decline, while the S&P 500 has seen a nearly 30% increase since late October without experiencing a single daily pullback of 2%, a rare feat according to Trade Algo.

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